Leonard Mlodinow of CalTech wrote a terrific short book on randomness titled The Drunkard’s Walk (recommend it highly). My favorite section deals with Bill Miller and the “hot-hand fallacy” – that past returns are not necessarily indicative of future returns.

As you’ll recall, Bill Miller was the portfolio manager for the Legg Mason Value Trust Fund, which was renowned for outperforming the S&P 500, net of fees, for fifteen straight (calendar) years starting in the early 1990s. Mlodinow does a terrific deconstruction of various biases in the data: how the weighting system in the S&P 500 depressed reported performance in certain years, how his streak would not have been nearly as impressive if non-calendar year intervals were used, etc.

But what I found most entertaining was his critique of a CSFB estimate of the probability of a manager outperforming the S&P 500 for a dozen consecutive years: 1 in 4,096, 1 in 477,000 or 1 in 2.2 billion. Needless to say, he mocks the need for three widely disparate estimates.

But then he further and elegantly argues that the true probability is closer to 75%. The low odds applied if someone had selected Bill Miller in particular at the beginning of 1991 and had calculated the probability that he specifically would have outperformed the S&P over the next ten plus years. Mlodinow reframes the question by asking, “what is the probability that one fund out of all funds would have outperformed the S&P 500 for any given fifteen year period?” Here the probability is quite high.

That said, there is something that feels quite non-random about Miller. He tended to make large bets, and they worked for a long time. When his streak ended, his performance didn’t revert to the mean, as implied by Mlodinow. He then subsequently ranked among the very worst large cap managers over the coming five years. As the Financial Times pointed out,

Bill Miller, a previous Morningstar manager of the decade, who could do no wrong through the 1990s, has struggled with poor performance since 2005. Now his Legg Mason Capital Management Value Trust is ranked last of the 840 funds in its category over the past five years by Lipper, losing 9 per cent annually.

Funds by definition are not entirely random. They are managed by individuals with particular investment biases, and those biases interact in complicated ways with a particular manager’s opportunity set. Warren Buffett was making very different investments in the 1960s than today, yet there are common elements in how he intrinsically approaches any investment prospect.

Where this becomes useful in thinking about hedge funds is that it helps to understand that past performance is not necessarily a good predictor of future performance. For one thing, as funds succeed, they tend to grow assets quickly and the opportunity set narrows radically. For another, market forces can be a critical determinant of returns and are too often overlooked as a contributing factor.

It’s also important to remember that managers will have a particular bias – value vs momentum, activism vs. passivity, asset classes, geographic regions, etc. As the business has become more institutionalized, the flexibility of managers to deviate from a core philosophy has been curtailed, despite the relative attractiveness of different areas. Consequently, when evaluating a particular fund, it is critically important to understand how these biases interact with the manager’s opportunity set.

The FT has a compelling cautionary tale on how yesterday’s stars can be tomorrow’s disasters.